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March 11, 2014

Taxation of 401(k) Distributions and Hardship Withdrawals

As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service,Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

What restrictions apply to distributions from 401(k) plans?

Amounts held by the trust that are attributable to employer contributions made pursuant to the election to defer may not be distributed to participants or beneficiaries prior to:

(1) the employee’s death, disability, or severance from employment;

(2) certain plan terminations, without the establishment or maintenance of another defined contribution plan;

(3) in the case of a profit sharing or stock bonus plan, the employee’s reaching age 59½ or experiencing financial hardship; or

(4) in the case of a qualified reservist distribution, the date of the reservist’s order or call.

The final regulations cited here were published in December 2004 and are effective for plan years beginning on or after January 1, 2006.

These occurrences are referred to as “distributable events.” Amounts may not be distributable merely by reason of completion of a stated period of participation or the lapse of a fixed number of years. A qualified hurricane distribution will be treated as satisfying the distribution requirements of IRC Section 401(k)(2)(B).

The cost of life insurance protection as per Table 2001 or P.S. 58 costs provided under the plan is not treated as a distribution for purposes of these rules. Neither is the making of a loan that is treated as a deemed distribution even if the loan is secured by the employee’s elective contributions or is includable in the employee’s income under IRC Section 72(p).

The reduction of an employee’s accrued benefit derived from elective contributions (i.e., an offset distribution) by reason of a default on a loan is treated as a distribution. The IRS has privately ruled that a transfer of 401(k) elective deferrals or rollovers to purchase service credits would not constitute an impermissible distribution from the plan and are not a violation of the separate accounting requirement.

Restrictions on distributions of elective contributions generally continue to apply even if the amounts are transferred to another qualified plan of any employer. Amounts transferred to a 401(k) plan by a direct rollover from another plan do not have to be subject to these restrictions. Final regulations state that rollover amounts may be excepted from the timing restrictions on distributions applicable to a receiving plan, provided there is a separate accounting for such amounts.

If an eligible retirement plan separately accounts for amounts attributable to rollover contributions to the plan, distributions of those amounts are not subject to the restrictions on permissible timing that apply, under the applicable requirements of the Internal Revenue Code to distributions of other amounts from the plan. Accordingly, the plan may permit the distribution of amounts attributable to rollover contributions at any time pursuant to an individual’s request.

Thus, for example, if the receiving plan is a money purchase pension plan and the plan separately accounts for amounts attributable to rollover contributions, a plan provision permitting the in-service distribution of those amounts will not disqualify the plan.

What requirements apply to hardship withdrawals from a 401(k) plan?

Hardship withdrawals may be made from a 401(k) plan only if the distribution is made on account of an immediate and heavy financial need and the distribution is necessary to satisfy the financial need. The distribution may not exceed the employee’s maximum distributable amount. Hardship withdrawals generally may not be rolled over. The final regulations cited here took effect for plan years beginning on or after January 1, 2006.

The Pension Protection Act of 2006 called for regulations modifying the hardship requirements to state that if an event constitutes a hardship with respect to a participant’s spouse or dependent, it constitutes a hardship with respect to the participant, to the extent permitted under the plan.

An employee’s maximum distributable amount generally is equal to the employee’s total elective contributions as of the date of distribution reduced by the amount of previous distributions on account of hardship.

The determinations of whether the participant has “an immediate and heavy financial need” and whether other resources are “reasonably available” to meet the need are to be made on the basis of all relevant facts and circumstances. An example of “an immediate and heavy financial need” is the need to pay funeral expenses of a family member. A financial need will not fail to qualify as an immediate and heavy financial need merely because it was foreseeable or voluntarily incurred by the employee.

A distribution will be deemed to be made on account of “an immediate and heavy financial need” if it is made on account of any of the following:

(1) “medical expenses” incurred by the employee, spouse, or dependents;

(3) payment of tuition, related educational fees, and room and board expenses for the next twelve months of post-secondary education for the employee, spouse, children, or dependents;

(4) payments necessary to prevent eviction of the employee from his or her principal residence or foreclosure on the mortgage on his or her principal residence;

(5) for plan years beginning on or after January 1, 2005, funeral or burial expenses for the employee’s parent, spouse, children, or other dependents (as defined prior to 2005); and

(6) expenses for the repair or damage to the employee’s principal residence that would qualify for the casualty deduction under IRC Section 165 (without regard to the 10 percent floor).

This list may be expanded by the IRS but only by publication of documents of general applicability. Apparently, to be the taxpayer’s “principal residence” for this purpose, the home must be the residence of the employee, not merely that of his or her family.

A distribution is not necessary to satisfy such an immediate and heavy financial need (and will not qualify as a hardship withdrawal) to the extent the amount of the distribution exceeds the amount required to relieve the financial need. The amount of an immediate and heavy financial need may include any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution.

The distribution also will not be treated as necessary to satisfy an immediate and heavy financial need to the extent the need can be satisfied from other resources that are reasonably available. A distribution may be treated as necessary if the employer reasonably relies on the employee’s written representation that the need cannot be relieved:

(1) through reimbursement or compensation by insurance or otherwise,

(2) by reasonable liquidation of the employee’s assets,

(3) by cessation of elective contributions or employee contributions,

(4) by other distributions or nontaxable loans from any plans, or

(5) by loans from commercial sources.

Notwithstanding these provisions, an employee need not “take counterproductive actions” (such as a plan loan that might disqualify the employee from obtaining other financing) if the effect would be to increase the amount of the need.

Regulations state that a distribution will be deemed to be “necessary” to meet a financial need (deemed or otherwise) if the employee has obtained all other distributions and nontaxable loans currently available under all of the employer’s plans and the employee is prohibited from making elective contributions and employee contributions to the plan and all other plans of the employer for a period of at least six months after receipt of the hardship distribution.

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